With its stock down 7.2% over the past month, it is easy to disregard Equity Residential (NYSE:EQR). It is possible that the markets have ignored the company's differing financials and decided to lean-in to the negative sentiment. Stock prices are usually driven by a company’s financial performance over the long term, and therefore we decided to pay more attention to the company's financial performance. Specifically, we decided to study Equity Residential's ROE in this article.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
How To Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Equity Residential is:
9.1% = US$1.0b ÷ US$11b (Based on the trailing twelve months to September 2020).
The 'return' is the yearly profit. One way to conceptualize this is that for each $1 of shareholders' capital it has, the company made $0.09 in profit.
Why Is ROE Important For Earnings Growth?
Thus far, we have learned that ROE measures how efficiently a company is generating its profits. We now need to evaluate how much profit the company reinvests or "retains" for future growth which then gives us an idea about the growth potential of the company. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.
Equity Residential's Earnings Growth And 9.1% ROE
At first glance, Equity Residential's ROE doesn't look very promising. Although a closer study shows that the company's ROE is higher than the industry average of 5.4% which we definitely can't overlook. But seeing Equity Residential's five year net income decline of 30% over the past five years, we might rethink that. Remember, the company's ROE is a bit low to begin with, just that it is higher than the industry average. So that could be one of the factors that are causing earnings growth to shrink.
That being said, we compared Equity Residential's performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 12% in the same period.
The basis for attaching value to a company is, to a great extent, tied to its earnings growth. The investor should try to establish if the expected growth or decline in earnings, whichever the case may be, is priced in. This then helps them determine if the stock is placed for a bright or bleak future. Is EQR fairly valued? This infographic on the company's intrinsic value has everything you need to know.
Is Equity Residential Making Efficient Use Of Its Profits?
Equity Residential seems to be paying out most of its income as dividends judging by its three-year median payout ratio of 64% (meaning, the company retains only 36% of profits). However, this is typical for REITs as they are often required by law to distribute most of their earnings. So this probably explains the company's shrinking earnings.
In addition, Equity Residential has been paying dividends over a period of at least ten years suggesting that keeping up dividend payments is way more important to the management even if it comes at the cost of business growth. Based on the latest analysts' estimates, we found that the company's future payout ratio over the next three years is expected to hold steady at 72%. However, Equity Residential's future ROE is expected to decline to 5.4% despite there being not much change anticipated in the company's payout ratio.
In total, we're a bit ambivalent about Equity Residential's performance. Specifically, the low earnings growth is a bit concerning, especially given that the company has a respectable rate of return. Investors may have benefitted, had the company been reinvesting more of its earnings. As discussed earlier, the company is retaining a small portion of its profits. Having said that, we studied the latest analyst forecasts, and found that analysts are expecting the company's earnings growth to improve slightly. This could offer some relief to the company's existing shareholders. To know more about the company's future earnings growth forecasts take a look at this free report on analyst forecasts for the company to find out more.
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